Fed passes the baton to the ECB

Mitul Kotecha is the author of the forthcoming Chronology of a Crisis (Searching Finance September 2012).

Although the Fed’s inaction overnight was perhaps a little disappointing for markets the FOMC did note that it “will” provide further stimulus to the economy if needed.

The USD rallied but risk currencies came under pressure. However, any sell off in risk assets will be limited as markets look to the FOMC meeting on September 13 for more action. This will also coincide with updates of the Fed’s economic forecasts.

The below consensus reading for the ISM manufacturing index in July which came in at 49.8 added to the slight disappointment, with the data consistent with flat growth in manufacturing.

Attention now turns to the European Central Bank (ECB).

Warnings by the Bundesbank President Weidmann for the ECB not to overstep its remit sets the scene for a stressful policy meeting today.

Although markets have pared back their overly bullish expectations from the end of last week a lack of action by the ECB to reduce peripheral bond yields will disappoint and lead to a sell of in risk assets and EUR/USD but support around 1.2150 is likely to hold. Even a restart of Securities Market Purchases on its own would not be a game changer.

The Bank of England also decides on policy today but unlike the ECB there is little expectation of any action from the MPC. Inaction by the BoE today will highlight that after a GBP 375 billion in asset purchases there is limited room in the tool kit aside from lowering interest rates further. A weaker than expected reading for UK July manufacturing confidence weighed on GBP, with the data following a rash of disappointing data releases over recent weeks. I continue to see downside risks to GBP both against the EUR and USD, however.

Indeed, my quantitative models reveal that GBP/USD should be trading around 1.5144 while EUR/GBP should be around 0.8242.